Friday, August 7, 2009

One more update in a long-running series of posts on the relation between the implied volatility of equity options (the Vix index) and the level of equity prices. It started out with the observation that this recession was mostly about a financial market panic; a sudden outbreak of fear that banks and major financial institutions were going to go bust and that would in turn bring about the end of the world as we know it.

Fears, doubts, and uncertainty reached a peak in November '08, and that peak coincided with the low in equity prices at the time. The Vix started to decline (a rising line in this chart), and equities began to pick up. But then equities collapsed into the first part of March even as the Vix continued to rise. I've explained this second dip in equity prices as the market's horrified reaction to the prospect of Obama managing to engineer a massive increase in government spending and an equally massive increase in tax burdens.

When Obama's agenda started running into trouble in mid-March, equities began to recover. With cap and trade and healthcare reform looking increasingly unlikely to pass, the risk of massive tax hikes has diminished, thus brightening the long-term outlook. At the same time, we are seeing increasing signs that the economy has hit bottom and is starting to turn up. Indeed, the good news is popping up like green shoots all over the place. So it is not surprising that equity prices are up 50% from the their March lows.

Is this a "bear market rally," or the real thing? I'm in the "real thing" camp. Even though I fear the economy will be saddled with the extra burden of bigger government and higher taxes, I have an enduring faith in the ability of the U.S. economy to overcome hardship and adapt. I don't think we'll see a robust recovery, but I do think we'll see a decent recovery, even though it won't result in a rapid decline in the unemployment rate, which might drift a bit higher (at this rate I doubt it will surpass 10%) before slowly declining over the next several years.

The Vix index is still high from an historical perspective, and credit spreads are also still quite high from an historical perspective. The economy is not completely out of the woods, but we are making substantial progress. Equities still have plenty of upside potential as economic and political tensions ease and the recovery slowly takes hold.

2 comments:

Could a rise in the VIX that is contemporaneous with a rise in equities be influenced by a change in investment/trading strategy as much or more so than a belief in underlying volatility? There are many ways to explain the rise in equities, and I agree with your assertions of fear subsiding, PE expectations, several anti-business policies being pushed aside, the reflation phenomena, etc. My question (or thought) is, and I don't know how to assess this other than anecdotally, but I see a possible investment trend in the short-term of increased appetite for options, both institutional and retail. If most people expect an L-shaped recovery for several years I'm not sure many new players could reconcile option prices with volatility expectations, setting up a bubble in options.

Regardless of this (but somewhat related), would you consider in many cases the VIX to be a lagging indicator of volatility more so than what it should be in theory, which is a leading indicator?

Greatly appreciate your time and blog, read and enjoy it as much as possible.

A rise in the VIX means almost by definition that the appetite for options is increasing (implied volatility is one very important determinant of options prices). Equity prices should almost always be an inverse function of risk (less risk translating to higher prices and vice versa). Even if you expect an L-shaped recovery, the fact that you are expressing a view that downside risk is being truncated (the flat part of the L) means that you should be willing to pay a higher price for risky assets. To have a bubble in options you would need to see the VIX trading at extremely low levels, and that would be much, much lower than we see today. I think the VIX could be a lagging indicator, since it must be at least a partial function of current volatility, but it must also be a leading indicator since it reflects expectations of the future.